At These Levels

This is the Fed minutes spike as it started exactly at the time the notes from the last meeting were released, but it's not sticking well. Read the minutes, as everyone else is doing so. Interesting spin.

The lonely Mr. Lacker wanted to hike rates because:

Mr. Lacker dissented because he believed that further tightening was needed to bring inflation down more rapidly than would be the case if the policy rate were kept unchanged. The inflation outlook had deteriorated in the intermeeting period; the recent surge in core inflation had persisted and appeared to be broad-based, while the revision of the national income and product accounts indicated a recent upswing in compensation and unit labor costs. Although real growth was likely to be somewhat lower in coming quarters, in his view it was unlikely to moderate by enough to bring core inflation down. He noted, moreover, that real short-term interest rates had fallen in the intermeeting period and were still low relative to rates typically associated with sustained expansions.

I've heard from plenty of knowledgeable people that sound like Mr. Lacker, a lonely voice at the Fed.

Nothing much happened in the stock market last week. If it doesn't go down right away, it must be up from here, right? Not exactly.

The markets are overbought and into negative seasonality. It's my view that the August rally was purely options-expiration related, plus it squeezed some shorts. Funny thing about those shorts, because when you squeeze them and there's no real buying behind the tape, the market falls afterwards, even without them. Still hate them?

This is how John Hussman sees the situation at present:

With recession signals increasing (though not yet enough to predict a recession with a high probability), it's useful to remember that stocks generally turn lower before the economy, with a lead-time of about 6 months. That may very well be the window we've entered here.

On the economy, the most recent data on housing starts continues to confirm a downturn in housing, which was also evident in the 4.10% drop in new home sales last month. That gives us a new point on our housing starts oscillator, which is already at a level consistent with potential recession.

Meanwhile, a few writers including Floyd Norris of the New York Times and Jim Stack of Investech have noted that new car sales are now down on a year-over-year basis. Norris notes that declines in new car sales by more than -2% on a year-over-year basis have always been followed by recessions. The latest year-over-year figure is -2.4%.

In terms of price/volume behavior, Lowry's notes that the market's recent bounce hasn't been driven by measurably increased buying demand, but rather by a “backing off” of sellers. That's not characteristic of sustained market advances. In a solid market advance, you'll tend to see a persistence of strong upside volume and price action, rather than the tepid and sporadic “wait and see” attitude we've observed from investors in recent weeks.

As always, our investment position will respond quickly to any change in the Market Climate we observe, and I don't rule out the possibility that such a change could be favorable. Still, my impression is that the market is displaying a sort of “calm before the storm.”

Hope you had a good summer. Things may be about to get interesting.

And this is how Andy Xie sees the longer-term outlook (my emphasis):

Towards Stagflation

While the goldilocks period may be ending, most central banks are not taking inflation seriously. The low inflation in the past has made central bankers confident that any inflation problem is likely to be short-lived. Hence, the Fed is guiding investors to ignore inflation today and focus on a low-inflation future that it promises slower growth will bring. The reluctance to tighten has created the global real policy rate of about half a percent compared to the average of 1.5% in the past 13 years. When the level of money is high and inflation is on the rise, a low real interest rate is likely to add fuel to the fire.

On the growth front, the biggest uncertainty is US consumption. As the US housing bubble bursts, US consumption could come down also. This is not assured. The US has developed an entrenched culture of ‘borrow and spend’. It allowed the US consumption to survive the tech burst, 9-11 and the energy shock. The ‘borrow and spend’ culture could allow US consumption to survive again.

If US consumption does not weaken with the US housing market, however, global inflation is likely to accelerate even faster, as growth will surprise on the upside, with real interest rate still low. Hence, central banks could be persuaded to raise interest rates again.

If US consumption does slow down, it may not be sufficient to bring down inflation. China has built a funding cushion to keep investment going for another year if its exports do not grow. The global economy will still grow close to its trend of 3.5%. Hence, growth will not be low enough for inflation to come down. The low real interest rate could continue to inflate the commodity bubble, causing more inflation.

A mild form of stagflation could happen in 2007 with growth at 3.5% and inflation 4% for the global economy. The bond market would not do well in such a scenario. The equity market would not perform well either, as interest rates remain high and earnings slow down with economic growth.

I'm a raging bull compared to Andy, but only relatively speaking.

I just got this from UBS:

-Investor Optimism Declines Further
-UBS/Gallup Index of Investor Optimism Reaches New Low for the Year at 53
-Seven in Ten Investors Say Real Estate Conditions are Getting Worse

NEW YORK, August 28, 2006 – Investor Optimism fell in August to a new low for the year, dropping two points to 53. Since January, the Index has been on a steadily declining trend, dropping 40 points. The UBS/Gallup Index of Investor Optimism is conducted monthly and had a baseline score of 124 when it was established in October 1996.

One key issue of growing concern to investors is the residential real estate market. Fifty-six percent of respondents rate conditions in the real estate market as “only fair” (44 percent) or “poor” (12 percent), a significant jump from the 46 percent who held these views in June and July. Additionally, 70 percent of investors believe that conditions in the real estate market are getting worse, up from 63 percent in June. Investor sentiment toward investing in real estate assets nationwide has also fallen. In August, 50 percent of investors said that now is a good time to invest in real estate related assets nationwide, down from 55 percent in June.

The vast majority of investors polled, 94 percent, continue to view energy prices as harmful to the investment climate. Respondents also believe that gasoline prices will continue to rise somewhat over the next three months. Investors are also greatly concerned about the unsettled geopolitical environment with 85 percent responding that they believe current international tensions are hurting the investment climate. Additionally, 75 percent are concerned about the Federal budget deficit and 72 percent worry about the danger of increased inflation.

“The drop in confidence in the real estate market reflects the economic data for that sector and suggests that investors are feeling the pinch in their local markets,” said Anne Briglia, Senior Fixed Income Strategist, UBS Wealth Management Research. “Although we have seen gasoline prices stabilize recently, investors are clearly worried about the implications of international tensions on future energy prices.”

www.bloomberg.com

It has to be noted that this is a monthly index (see chart above) and it's different from other weekly sentiment readings, like those from the American Association of Individual Investors (AAII). The AAII numbers show 39.35 percent bulls, 32.23 percent neutral and 37.42 percent bears. There are more AAII bulls than bears at present. At the July lows on the major averages there were 2.42 bears for every bull, so the UBS numbers don't show that sentiment is overly bearish for the stock market, in my view, as they get a big impact form real estate, which is not part of the AAII numbers.

In an e-mail to subscribers last night I expressed the opinion that the bonds have focused on the economic slowdown and don't care about any inflationary threat:

The US bond market has been sending a consistent message: There’s an economic slowdown on the horizon. The 10-year Treasury note yield is far below the fed funds rate--forming the dreaded inverted yield curve, the classic slowdown signal. The 10-year Treasury yield was as much as 45 basis points below the fed funds rate, which stands at 5.25 percent as of August 22.

The bonds are saying two things here. The consensus in the bond market suggests the Fed is done tightening; this wasn’t a pause in August, but an end to the tightening campaign. Fed funds futures for December indicate a 30 percent chance (at most) of another rate hike, and despite what the relevant data suggest, that inflation won’t be a problem in 2007. In other words, the bond market agrees with Fed Chairman Ben Bernanke and is giving him the benefit of the doubt. For a while, Bernanke looked rather feeble.

Also:

www.stockcharts.com

Bonds have rallied big time on the slowdown in economic activity (see the chart above), but they may be celebrating an inflation slowdown that isn’t there. It’s an interesting situation: The 30-year bond price is right at major resistance at its 200-day moving average, under what futures traders call a massive head-and-shoulders top.

This interplay between inflation numbers and a weakening economy will be more difficult for the bond market in the weeks ahead because I don't think any inflation surprises are priced into bonds at current levels. The likelihood of inflation data surprising to the upside simply prevents me from making aggressive bets that interest rates will decline expeditiously. They may decline in 2007, but I still wonder (and perhaps I’m too cautious) if they won’t come down from higher levels.

I won't repeat why inflation may turn out to be higher than expected. A simple search for inflation on the blog gets you the results (scroll down). So far today, the S&P 500 was ambushed just under 1,300 by some patient sellers. The market has not broken down beyond any repair, yet. But the bonds and the performance of retailers (see below) suggest that something is amiss.

www.stockcharts.com

The existing home sales number was a disappointment and clearly hit the futures when it came out at 10 am. I'm curious to see if it sticks. A hit for the stock market is a boon for the bond market, even though both the stock and bond markets are overbought, as noted by John Hussman yesterday.

Existing home sales are now down 11.2 percent form last year (rate of change is on the lower pane) and, at an annual rate of 6.33 million, can easily slip into the five million range as the real estate drama progresses. For those of you who look at such things, they also appear to have broken a head-and-shoulders top, which also suggests a return to that 5 million-ish annual rate.

www.bloomberg.com

Now, I wish you all good luck with your real estate endeavors. I've been a home owner for the past four years and I do enjoy living in my own house. Houses are for living in, not speculation. But, unfortunately, we'll find out how this speculative story unravels soon. Doug Kass has an idea here. He used to be a homebuilding analyst in his younger days.

This is the last you'll hear form me from me today. I'll try to check in tomorrow afternoon as I'll be out of the office in the morning. I see more downside than upside from current levels in the stock market and I'm talking my book when I say it. That much I can say for disclosure. Be careful. It was a nice rally, not the beginning of a multi-month move higher. Play defense. This is what I've been doing all year with model portfolios I'm responsible for. Come to think of it, I always play better defense than offense, but I like it better that way because we know who gets the glory and who wins the game.

UPDATE 6.40 PM

The new home sales number tomorrow at 10 am may be relatively much worse than the existing home sales number today. New homes are generally more expensive and homebuilders have been seeing a lot of cancellations and have been walking away from land options. Is that "surprise" in the stock market? The one today was not.

I was wondering what was driving the buyers this morning. I no longer have bullish trading positions to capitalize on any move higher as of Friday and any rally form here without me would have been annoying. Actually, it would be expensive given that the trading positions that I have are there to capitalize on a decline.

I don't mind being early; I mind being too early with these trades. I went to lunch, I came back and I see the indexes scraping the opening lows. Will they break them?  This is a minor reversal in an overbought tape that went for all of last week up on light volume. We have to see a decline below 1290 on the S&P 500 to have faith in a reversal here and a decline below 1280 to give you the high odds that there is much more selling coming down the road. We are not there yet.

About that inflation data that excited the market last week, the honorable Dr. Hussman has some interesting news this week (my bolds):

A Turn in Inflation?

The markets took heart last week in a modest decline in the Producer Price Index, as well as a core CPI inflation rate that came in a pip (0.2% versus expectations of 0.3%) below expectations. The market reacted with the same delight as a starving man finding a hamburger. No matter that the burger was in the middle of the street and had just been run over by a truck. The market was starved for good news, and at least this was something.

Despite the market's reaction, the hope that inflation is slowing is hardly supported by the data. The “great news” on the CPI wasn't even outside the bounds of rounding error, while the PPI figures were actually of significant concern. Sure, the prices of some volatile items like eggs and fish fell steeply, but the improvement in the PPI for “finished goods” was overshadowed by continued pressure in the PPI for “intermediate goods.” Here's the picture that concerns me.

www.hussmanfunds.com

Over the past year, consumer price inflation has clocked in at 4.15%. Producer price inflation (finished goods) has been a similar 4.12%. But if you look at intermediate goods, we're currently at an inflation rate of 8.83%. That's the most abrupt widening in the spread between intermediate and finished goods since the 1973-74 oil crisis. Moreover, if we look at points in history when prices for intermediate goods have outpaced prices for finished goods over a 6-month period, we've also seen, on average, an acceleration in the PPI finished goods inflation rate over the following 6 months.

So if there is credible evidence to be found of weakening inflation pressures, it wasn't to be found in last week's CPI or PPI reports. About the best that can be said is that lower interest rates might take monetary velocity down a notch, but given that those lower rates were probably largely an overreaction, any favorable implications for inflation also require those lower rates to stick. At this point, both stocks and bonds are overbought, which will make the next several weeks very interesting.

As usual, we'll act on evidence from valuations and the quality of market action as it emerges. Regardless of my expectations regarding inflation, the economy or other factors, the prevailing Market Climate holds sway over our investment stance. For now, we remain defensive.

To read about how even a deep fundamentalist has found a way to remain objective and not fight the tape, you can see the whole report here.

Personally, I believe that this rally is a fakeout. I know I've been bullish for the past month on a tactical basis, but I've found over the years that pragmatism works best in the market and digging your heels is only a recipe for disaster, so I try to adjust and fight my biases accordingly.

To put my money where my mouth is I took a bearish position in the same stock that I was long for the past month until Friday, as I believe that nothing other than the option expiration was dragging it higher. I may be early here and I won't disclose that particular equity as this isn't a trading service. It's a blog.

I don't think it's necessarily straight down from here toward a retest of the June lows. If last week's rally has any validity, the fist pullback should be bought. Again, I have my doubts. In 2000, the high tick of the summer rally was the day before the long Labor Day weekend.

My point is, be careful. This was a low-volume rally right into options expiration in mid-August. They tend to puke out those stocks that rose only to have the August puts expire worthless right away the following week. It's happening today.

Jeffrey Saut of Raymond James has his own doubts about the rally. He was bullish off the June lows and somewhat bullish off the July retest. He's not too bullish now.

SPX 1302.30

OEX 601.50

QQQQ 38.80

The Friday close was as expected, but I still wonder how they manage that organized chaos, even though I have an idea of the tools involved in the process.

This is what I said yesterday in an e-mail to subscrivers:

...inflation expectations are about the same as where they were when the Fed started hiking the fed funds rate in mid-2004. Those expectations have fallen a bit during the past week; but if indeed the drop in the PPI were just a statistical quirk, they may not stay subdued in the coming months.

www.bloomberg.com

The difference between the headline inflation rate and the core inflation rate (the one that excludes food and energy) has only been this high in the mid- and late-1970s, when we had an inflation problem (see darker line). I must also note that while this inflation problem was being created, the real fed funds rate was mostly in negative territory for the three years between October 2002 and October 2005. The real fed funds rate (adjusted for the headline inflation rate) was only marginally in positive territory three of those 36 months. It's now just 1.15 percent, based on the latest data, which is very low by historical standards. A negative real fed fund rate was also a hallmark of the '70s. Is the Fed behind the curve?

As I've noted here previously, I don't have much faith in inflation excluding food and energy as that measure was invented to disguise the horrific inflationary problem of the '70s. Plus, credible experts have real concerns about the way the current inflation numbers are derived (see the PDF report from Weeden & Co mentioned here previously).

After all that, I'd admit that the action in the bond market in the past month suggests that the big money thinks the worst is over for the bonds. The Bond King himself said so recently (a link to his commentary was provided last issue as well). In an industry where the weight of your word is as big as the size of the money behind it, you should consider what Bill Gross is saying. But you also shouldn't forget that he's a mortal, too.

Andy Xie of Morgan Stanley this morning has a great report that deals with those issues:

Real Interest Rate Is Low, Inflation Is High and Rising

The basic reason for rising inflation is that global real policy rates are less than half of, and global inflation 50% above, average levels over the past decade.  Real interest rates are not high enough to exert a headwind against inflation.

The risk of accelerating inflation is even higher, considering that central banks have pumped enormous liquidity into the global economy over the past decade.  Until recently, the inflationary effect of the liquidity was held back by deflationary shocks.  Instead, the money inflated asset markets, which, in turn, boosted global demand.

As the effects of these deflationary shocks are wearing off, the stock of excess money in the financial system is turning into inflation through rising commodity prices, rising wages, rising rents, etc.  To hold back inflation, real interest rates therefore need to be higher than at a similar stage of the prior business cycle.

The Fed has a story for those with inflation concerns – i.e. the weakening housing market will slow the US economy, which will bring down inflation.  A side story is that the base effect from high oil prices will run out.  The Fed wants to focus the discussion on the technical factors of inflation rather than the fundamental factors such as real interest rate and money supply.

Global inflation is already at a ten-year high and is likely to rise further.  The bottom line is that money supply is too high and real interest rates too low for price stability.  If oil prices stabilize, inflationary pressure will likely shift to other areas.

The whole report is here. He does admit later on that there is a deflationary threat from housing.

I have not had much time to deal with the blog this week. I promise a longer post tomorrow morning. But, so far, this action is fairly predictable. The oil futures losing $70 intraday helped the bullish case.

Now, it would be too obvious, but the S&P 500 looks to be glued to 1300, the S&P 100 to 600 and the QQQQ to the 39 strike for tomorrow's expiration. The S&P 500 options expire tomorrow at the open, which has multiple pricing issues, while the S&P 100 trade all day till 4.15 pm. Once I managed to sell an OEX option for more money than the intrinsic value of the option in the chaos between 4-4.15 pm when everyone is squaring positions. I think someone on the other side made a mistake or just hit the button on a marketable order and my ask limit price just happened to be in line.

Doug Kass has more missives on TheStreet.Com:

Factors Aligning Against the Boom Cycle

Retail Looks Like a Short

Guess if I agree with those?

The numbers are irrelevant if their spin fits the agenda (exiration).

I want to say that it was obvious that tame inflation numbers would produce such a violent response, especially under the current conditions (see yesterday’s post). But in reality, it was getting hairy yesterday afternoon. The market was failing yet again to hold impressive gains from the morning. The severity of the move is probably due to the fact that some overzealous shorts took advantage of that weakness yesterday betting that the inflation numbers will surprise to the upside.

That was the wrong bet. I have been betting with this market recently for reasons outlined here on numerous occasions as I was looking for the rally to extend into late August. It was not paying off on either side, unless you wanted to take an intraday perspective.

Now, if the CPI numbers tomorrow are tame, the intraday highs from August 4 at 1292 on the S&P 500 will be taken out. How far the rally will go I cannot be sure, but my gut feeling is that it is not yet over. I do not see new highs in the major averages in the process and I do think that the rally will fizzle out and the market will roll over in late August early September. September is the worst month of the year – seasonally speaking—and the only month with better than 50 percent chance of being negative over a 50 year period. Until then, trade with the options’ dealers that are doing a picture perfect job of expiring those August puts out of the money.